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Over the last four months rating agency downgrades of Puerto Rico’s debt have shaken bond investors.

All three major rating agencies now rate the commonwealth’s general obligation bonds at the last notch above speculative grade. Two of the agencies have lowered other Puerto Rico government debt to speculative grade.

The commonwealth had $10.6 billion in GO debt as of Dec. 31, 2012, according to the Government Development Bank of Puerto Rico.

Eight well-known analysts of Puerto Rico surveyed for this story said a default on at least Puerto Rico’s general obligation debt is highly unlikely in the next years. They differed on the wisdom of holding the debt.

Troy Willis, senior portfolio manager for Oppenheimer Funds, said his group was “bullish” on owning Puerto Rico. On the other hand, Daniel Berger, senior market strategist at Municipal Market Data, wrote on March 20 that it was “difficult to recommend purchase” of Puerto Rico bonds.

The analysts point to several economic and political factors in assessing the GO debt.

One obvious factor is that Puerto Rico has high levels of debt outstanding by most measures. In the 12 years through 2012, island GNP grew by 4% annually, though slower in recent years, while public debt had a compound annual growth rate of 9%, pushing the ratio of debt to GNP above 100%, compared to 58% in 2000, according to Alan Schankel, managing director at Janney Capital Markets.

According to a June 30, 2010 Standard & Poor’s report, Puerto Rico’s per capita tax-supported government debt was 6.7 times larger than the U.S. state average.

However, “it could be argued that because bona fide Puerto Rico citizens do not pay federal income taxes, the crushing burden of the federal government’s debt does not weigh on most Puerto Rico residents,” wrote Richard Larkin, director of credit analysis at HJ Sims.

Analysts say that the government’s lack of funding for its pension system has cast a shadow on its financial future. The government’s main retirement fund has only six cents for every dollar actuarially required. Its other systems are funded at better though still low levels.

In February new Puerto Rico Gov. Alejandro García Padilla proposed new reforms to the main retirement system to assure its solvency over the long term. On Thursday Puerto Rico’s legislature passed the reforms, and García Padilla signed them into law.

Even that might not be unalloyed good news for the credit. Adoption of the pension reforms effective July 1 would probably lead to a wave of retirements before then to take advantage of the earlier plan’s better terms, said Robert Donahue, managing director of Municipal Market Advisors. In the long term this may be good for the government financially, but in the short term the government will have to pay for unused sick leave and vacation time, he said.

Joseph Pangallozzi, managing director at BlackRock, was among several analysts to cite the pension reform as a financial positive for the Puerto Rico government.

Puerto Rico’s government is handicapped by its residents’ low income levels, Larkin and Donahue said. In 2011 Puerto Rico’s median household annual income per person was $7,135 versus the United States median of $20,450, according to the U.S. Census.

Several analysts said that the commonwealth’s weak economy is a major concern. The island’s unemployment rate of 14.5% is below the peak of 16% in 2010, but still well above the U.S. rate of 7.6%. The main index of economic activity showed some growth in early 2012 but has since shown modest declines.

Partly because of the weak economy, an unexpectedly large gap between revenues and expenditures is anticipated in the current fiscal year. When the fiscal 2013 budget was adopted in mid-2012 the commonwealth’s government anticipated an operating deficit of $332 million, or 3.7% of budgeted expenses of $9.08 billion. It also anticipated a structural budget gap of about 10% of expenditures.

As of March the government was anticipating a $2.157 billion structural operating deficit, absent corrective action. This would be 22% of the revised and higher estimate of expenses.

While the deficit poses a big problem for the government, analysts say that both the previous and current governors have taken encouraging steps towards fiscal discipline.

García Padilla took office in early January. Since then his administration has dramatically raised water rates, gone forward with a previously planned privatization of the island’s main airport, pushed through pension reform, and passed a higher tax rate on off-island based companies operating in Puerto Rico effective July 1, Donahue said.

Larkin, one of the optimists on Puerto Rico, says García Padilla’s actions have been encouraging. Larkin also points to several factors that make him a believer in holding the territory’s GO bonds for the medium or long term.

Unlike Illinois and California, Puerto Rico has no constitutional or voter approved limits to its taxation, Larkin wrote. States in general have one of the lowest levels of default and Puerto Rico has most state powers.

The Government Development Bank of Puerto Rico is another advantage for Puerto Rico, Larkin wrote. The GDB can offer short-term debt to some of the commonwealth’s public utilities. It has improved the transparency of the commonwealth’s debt, he wrote.

Further, “in the worst case, Puerto Rico could be compared to New York City in the 1970’s – high debt, large deficits, and a weak economy,” Larkin wrote. Just as with New York City, Puerto Rico may be “too big to fail.”

When New York City struggled, New York State stepped in to create a conduit borrower to create access to credit. If Puerto Rico were to flounder, the federal government would probably provide assistance, though it would probably not provide money, Larkin said.

Schankel sees it differently. “I think Puerto Rico is in a much deeper hole than New York City was and other cities are because of how the economy has been and the massive amount of debt they have,” he said. New York City’s problem was more with liquidity than debt, Schankel said.

When asked about the likelihood of Puerto Rico defaulting on its GO debt in the next 10 years, Larkin, Pangallozzi, Willis, Donahue and Barclays director of municipal research Thomas Weyl all said it was very low. Schankel said it was low in the next two years but did not want to speculate beyond that time frame.

Several analysts said the danger to holding Puerto Rico GOs now was not a default but connected to yields, prices and a possible downgrade to a speculative rating.

One analyst said that investors will want an additional 20 to 25 basis points to make it worth investing. The market is asking for more yield than other BBB-minus debt offers for good reason, said John Mousseau, executive vice president of Cumberland Advisors.

Several analysts said a downgrade of the GO debt to speculative grade, just one more notch, is a real possibility in the next year or two. Many mutual funds and others would immediately sell, Berger said. The wave of selling could lead to reckless selling, where funds and individual investors would get bad deals.

Several analysts agreed that the price of Puerto Rico bonds could go down in the next few years, a potential problem for those who currently hold them.

For investors who want to hold the bonds to maturity or long term, they are good, Larkin said. They are also good for those looking for a solid income stream, he said.

Schankel said he thought the Puerto Rico Sales Tax Financing Corp., or COFINA, sales tax bonds were a better choice for investors than Puerto Rico GOs. Tax collections are held by COFINA until debt service payments are due and are not subject to diversion to the government’s general fund.

Larkin, however, notes that the Puerto Rico constitution guarantees that the GO bonds get first lien against the government’s revenues. If the government were to renege on the GO bonds, than the commonwealth’s protections of the COFINA revenues from the government would also have to be suspect, Larkin said.

The GO bonds’ high yields in the secondary is an example of the market overreacting to negative headlines, Larkin said.

The García Padilla administration and the GDB chose not to comment for this story. However, the GDB has posted slides of an investor presentation it made in March. Among the points it made were that the government is addressing the retirement system’s situation and has taken measures to address fiscal imbalances, like the water rate hike and bringing debt relief to the ports authority.

Further, the GDB noted the increase to the tax on off-island based corporations and the tax’s extension for five years. The government has taken steps to address the current fiscal year’s general fund imbalance. Finally, the government has taken a step to improve the important tourism sector by getting significant capital improvements promised by a private firm for the island’s main airport, the GDB said.